Last spring I argued, in an essay entitled Japan's
trap , that the natural answer to Japan's liquidity trap is a deliberate,
announced policy of moderate inflation - and that monetary policy is ineffective
precisely because the private sector expects the Bank of Japan to behave
responsibly, so that current monetary expansion does not change expectations
about future price levels. The essay, its sequel
, and a technical
paper for Brookings created a flurry of interest, but unsurprisingly
has not altered the course of actual Japanese policy. Instead conventional
"canons of soundness" - a continuing commitment to stable prices
and to a strong or at least not too weak yen - have thus far prevailed.
Japan's recovery strategy, such as it is, involves expansionary fiscal
policy together with bank recapitalization; while the Bank of Japan has
actually been engaging in some quite unconventional monetary operations
(lending directly to troubled firms, with their debt as collateral), it
is doing so in a surreptitious, almost shamefaced manner, and therefore
not creating the sort of "credible promise to be irresponsible"
that I argued was necessary.

But this story is far from over. Indeed, events in the last few months
have only strengthened the case I made last spring. As I suggested in the
original piece, Japan's fundamental currency problem is not an excessively
weak yen but a yen that, absent a commitment to inflation, tends to be
too strong to effect the necessary export of capital; certainly the recent
runup in the yen makes that position more comprehensible. The actual prospect
of bank recapitalization also makes it much clearer than before that fixing
the banks, while necessary on its own merits, is unlikely to do much to
solve the economy's macroeconomic problems. And recent headlines about
both the size of Japan's prospective budget deficit and the decision of
Moody's to downgrade Japanese bonds suggest that the limits to fiscal policy,
if they have not already been reached, will be reached soon. So the time
seems ripe for a restatement of the argument that what Japan needs is moderate,
"managed" inflation.

In addition to reemphasizing the case for Japanese inflation in the
light of recent events, this note has a secondary purpose: to try, once
again, to make it clear that this is not an outlandish or peculiar proposal.
On the contrary, the proposition that the Japanese economy needs a negative
real interest rate, which means that it needs expected inflation, is a
direct implication of the same framework that most working macroeconomists
routinely use for policy analysis. The utter conventionality of my reasoning
may have been obscured in the earlier essays by the use of an "intertemporal
maximization" framework, something I felt was necessary in order to
avoid certain kinds of confusion. (If you really want to know, I had initially
believed that the "Pigou effect" might play an important role
in the discussion, and needed the intertemporal model to convince myself
that it did not). In any case, this time I present the argument in terms
of an absolutely conventional open-economy IS-LM model, exactly the same
model that is presented, say, in the Krugman-Obstfeld international economics
textbook or Olivier Blanchard's macroeconomics textbook.

This essay is in four parts. The first part revisits John Hicks' original
statement of the IS-LM model, and shows that in that most conventional
of macroeconomic models the statements that "the economy is in a liquidity
trap" and that "the full-employment equilibrium real interest
rate is negative" are essentially equivalent. The second part opens
the economy up to both goods and capital mobility, showing that - once
again in the most conventional of frameworks - a liquidity trap can occur
in an open economy, and that when it does it involves a currency that cannot
be made weak enough. The third part discusses the continuing relevance
of this analysis to Japan. A final section offers some reflections on the
debate.

1. The real interest rate and the liquidity trap

Let's start where Hicks did in his original exposition of the IS-LM
model, back in 1937: with savings and investment. As Hicks pointed out,
the "classical" theory of the rate of interest was that it was
determined by the requirement that desired savings equal desired investment,
as in Figure 1 . But once one considers the possibility
that the economy will not produce at full capacity, one realizes that savings
and investment are contingent on the level of real income as well as the
real interest rate - that they should be written as S(r,y) and
I(r,y). This does not make Figure 1 wrong; but it means that it shows
the equilibrium real interest rate only at a particular level of real output.
An increase in real output would presumably increase both savings and investment
at a given real interest rate; but the conventional assumption is that
it increases savings more, so that the real interest rate falls. By considering
all possible levels of real output, then, one sweeps out the IS schedule
of Figure 2 , which is defined by the equation

S(r,y) = I(r,y)

Meanwhile, of course, the money market must also clear; the conventional
equation is simply

M/P = L(y, i)

where i is the nominal interest rate, the real rate plus expected
inflation. To draw the implied LM curve one must specify the expected rate
of inflation; Figure 2 is drawn on the assumption that expected inflation
is zero.

Even without specifying the details of money demand, it is immediately
apparent that the LM curve cannot go below zero, for the simple reason
that at a negative nominal interest rate cash would dominate bonds as a
store of value. Thus whatever the LM curve looks like in the "normal"
range, its overall shape must be pretty much as illustrated in the figure,
with its left portion flat at or near a zero interest rate. And if the
IS curve happens to pass through that flat section, the economy is in a
liquidity trap: the interest rate is hard up against the zero constraint,
and cannot be reduced through monetary expansion.

All this is the most basic textbook stuff. But in Figure 2 I have put
in a bit more than the textbook usually does, by indicating the "full
employment" level of output yf and showing the continuation
of the IS curve, beyond a zero real interest rate. What is immediately
clear from this more complete version of Hicks' picture is that if an economy
is in a liquidity trap, it must be the case that savings would exceed investment
at full employment even at a zero real interest rate - that

S(0, yf ) > I(0, yf )

In terms of the original savings-investment diagram, then, if we draw
the curves at the full-employment level of output they must look like Figure
3 .

And what both figures make clear, of course, is that the problem is
not that there is no real interest rate that will make savings and
investment equal at full employment; it is that the full-employment real
interest rate is negative. And monetary policy therefore cannot get the
economy to full employment unless the central bank can convince the public
that the future inflation rate will be sufficiently high to permit that
negative real interest rate.

That's all there is to it. You may wonder why savings are so high and
investment demand so low, but the conclusion that an economy which is in
a liquidity trap is an economy that as currently constituted needs
expected inflation is not in the least exotic: it is a direct implication
of the most conventional macroeconomic framework imaginable.

2. The open economy

Perhaps the most common objections to the foregoing analysis involve
the openness of the Japanese economy to international capital flows. Some
argue that as long as there are positive-real-return investments abroad,
a liquidity trap cannot happen; others that "managed inflation"
would lead to a collapse in the yen, and/or would fail to stimulate the
economy because the capital would simply flee abroad. Well, there is a
standard way to introduce exchange rates, capital mobility, and international
trade into the IS-LM framework; let's see what it says.

Start with the goods market: in an open economy the savings-investment
identity must be extended to take account of net exports, with the conventional
version looking like this:

S(r, y) - I(r,y) = NX(e, y, y*)

where e is the logarithm of the real exchange rate, measured
the non-Anglo Saxon way (higher means weaker currency). I include foreign
output y* simply as a matter of completeness.

The crucial question then becomes, what determines the real exchange
rate? A standard answer (used, for example, in the Fed's Multi-Country
Model) is some version of the "anchor" model. We imagine that
investors have some notion of the long-run equilibrium real exchange rate
- call it eL. Ignoring issues involving investment income,
we may think of this long-run rate as corresponding to zero net exports
at full employment; that is, eL is implicitly defined
by

NX(eL , yf , y*) = 0

We suppose that investors expect the actual rate to converge gradually
toward that long run value over time, say by eliminating a fraction g
of the gap per year. We also imagine that expected returns on domestic
and foreign bonds are equalized. This implies the arbitrage equation

r - r* = g(eL - e)

where r* is the foreign real interest rate, and hence the real
exchange rate equation

e = eL - (r - r*)/g

So the real exchange rate, and hence the level of net exports at any
given level of real output, depends on the real interest rate.

Three points should now be immediately apparent.

First, a zero or even a negative real interest rate does not mean that
the currency will drop without limit. The reason is that as long as people
have some notion about what constitutes a "normal" real exchange
rate, a current real rate much weaker than that normal level will imply
expected real appreciation in the future - which will make domestic bonds
an attractive asset even if their real return is negative in terms of the
domestic price index.

Second, because the real exchange rate does not depreciate without limit,
even a negative real interest rate implies only a finite value of net exports
at any given level of output.

Third, this means that even an economy that is completely open to capital
movement can still suffer from a liquidity trap. Figure
4 illustrates this possibility, showing the savings-investment gap
and the level of net exports as functions of the real interest rate, both
contingent on the full-employment level of output. The reason net exports
depend on the real interest rate is, to repeat, that the real interest
rate determines the real exchange rate, which in turn determines net exports
for any given y. (Given the assumption that eL
implies zero net exports at full employment, we have NX = 0 when
r = r*).

As drawn, getting S-I equal to NX at full employment requires a negative
real interest rate; if expected inflation is insufficient, a zero nominal
rate will be insufficient to get the economy to full employment, and the
economy will find itself in a liquidity trap in spite of its ability to
export savings abroad. (The ability to export capital makes a liquidity
trap less likely, because now even a country whose full-employment savings
exceed investment at a zero real interest rate need not be in such
a trap; but it still can find itself liquidity-trapped).

How is this possible? Because expectations that the real exchange rate
will tend to revert to its "normal" level limit the extent of
real depreciation, even at a zero real rate. So the country cannot get
its currency weak enough, where the criterion for "weak enough"
is "weak enough to produce a current account surplus large enough
to absorb the savings-investment gap at full employment". And one
of the reasons expected inflation is necessary is precisely to achieve
a weaker real exchange rate than would otherwise be possible.

Again, this is the natural conclusion from the textbook model. If you
feel that this framework is too ad hoc, you can check the logic against
the implications of more micro-founded models - and I have. It turns out
to stand up quite well.

Given how conventional the reasoning is, the opposition to its conclusions
is therefore a bit puzzling. I was fairly amazed when The Economist,
which usually gets such things right, bought into the naive objection of
some commentators that expected inflation would be ineffective, because
it would simply lead the Japanese to "plonk" their savings abroad.
Because capital account plus current account must equal zero, any capital
export by Japan would necessarily have as its counterpart an increased
current account surplus - which means that it would help close the savings-investment
gap. So plonking is exactly what the doctor ordered - and in any case,
the incentive to plonk is already taken account of by the standard framework.
Slightly less amazing, but still a bit puzzling, is the common objection
that pushing the real interest rate below zero would weaken the yen. Indeed
it would - but that is true of any interest rate reduction. If Japan currently
had 5 percent interest rates, but its macroeconomic situation was otherwise
the same, there would be almost universal approval for rate cuts by the
Bank of Japan. What's so special about zero?

Still, many people clearly are made uncomfortable by the idea of deliberately
seeking inflation, and the Japanese government is trying other ways of
getting the economy moving. Is the assessment that the economy needs a
negative real interest rate still valid?

3. Japan's current situation

I cannot see any way to deny the proposition that the Japanese economy,
as currently constituted, would need a negative real interest rate
to achieve full employment. To argue that inflation is unnecessary, then,
one must believe that other policies can shift the savings and/or investment
schedules sufficiently to make the required real interest rate positive.

The most commonly cited policy instrument is bank reform. Although clear
thinking is not exactly prevalent in this discussion, presumably the idea
is that Japanese investment is depressed because undercapitalized banks
are unable to provide firms with adequate credit. I have criticized this
view in an earlier note, and discussed the role of financial intermediation
at length in my Brookings Paper. Let me simply reiterate the main points.
First, Japan has not suffered from anything like a bank run; and as long
as undercapitalized banks have no trouble retaining depositors, economic
logic suggests that they should if anything lend too much rather than too
little. Second, even anecdotal evidence of credit constraints dates, at
the earliest, from late 1997; there is no evidence at all for the idea
that the prolonged stagnation of the economy before then was due to inadequate
intermediation. Third, while tightening of capital standards has led to
some complaints about credit constraints over the past year, much of this
probably represents banks acting more, not less, appropriately.

That said, it is possible that recapitalizing the banks will reverse
some of the recent credit squeeze - if only because the regulators will
decide, once again, to look the other way. But this would at best only
return Japan to the very unsatisfactory status quo ante; it is highly unlikely
that it would shift the investment schedule out sufficiently to resolve
the liquidity trap.

Which leaves us with fiscal policy - essentially, resolving the savings-investment
gap by having government deficits absorb the excess savings.

One question one might ask about the idea of resolving Japan's trap
with deficit spending is, why would this be considered a preferred alternative
to a negative real interest rate? Suppose that the private sector is so
into deferred gratification that at the margin it is willing to trade off
one real yen of consumption now for slightly less than one real yen in
the future. What's wrong with that? Why force the public to consume more
now and less later than it apparently wants to? Do we regard price stability
as so important a goal that it trumps the usual principle that prices (such
as the real interest rate) should be allowed to reach a level that matches
supply and demand?

But anyway, as a practical concern the main point about fiscal policy
in Japan is that it is clearly nearing its limits. Over the course of the
past 7 years Japan has experienced a secular trend toward ever-growing
fiscal deficits; yet this has not been enough to close the savings-investment
gap. One need not claim that fiscal policy is completely ineffective: as
Adam Posen has emphasized, fiscal expansion has pushed up Japanese growth
when tried. But how much fiscal expansion can the government afford? Between
1991 and 1996 Japan's consolidated budget went from a surplus of 2.9 percent
of GDP to a deficit of 4.3 percent, yet the economy was marked by growing
excess capacity. When the Hashimoto government, alarmed by the long-run
fiscal position, tried to narrow the deficit in 1997 the result was a recession;
now fiscal stimulus is being tried once again. But projections already
suggest that Japan may be heading for some awesome deficits - say 10 percent
of GDP next fiscal year - with no end to the need for fiscal stimulus in
sight. Given that Japan is already in far worse fiscal shape than, say,
Brazil on every index I can think of - not just current deficit, but debt
to GDP ratio and hidden liabilities arising from an aging population,
the need for bank and corporate bailouts, etc., one has to wonder where
the fiscal-expansion strategy is leading.

4. Reflections on the debate

Any economist who knows his theory but has also watched real-world policymaking
knows that there are actually two quite different sorts of "conventional
wisdom" in the world of economic affairs. On one side there are the
standard, textbook economic models - like the IS-LM model - that shape
informed policy analysis and discussion. On the other there are the "canons
of orthodoxy and 'soundness'" (the phrase is from Ragnar Nurkse's
International Currency Experience) that define what a responsible
central banker is supposed to sound like. Nurkse went on to point out that
"It is characteristic of such canons that they tend to assume an independent
existence of their own." That is, the canons may not correspond very
closely to what the models say. Certainly nothing in the textbooks suggests,
to take a non-random example, that price stability is as important a principle
as most finance minsters and central bankers suppose it to be. Still, most
of the time the standard textbook analysis and the orthodoxy of central
bankers are at least reasonably in accord.

But what happens if a change in circumstances places bankers' orthodoxy
and basic economic analysis in conflict? That, I would argue, is what has
happened in the case of Japan. The standard macroeconomic model that we
all use to make sense of the world tells us, quite clearly, that this is
an economy that "wants" a negative real interest rate; yet the
bankers' orthodoxy regards price stability as an excellent thing, not to
be compromised. Which side do we take?

It is easy to understand why government officials and many journalists
would end up choosing the bankers' orthodoxy. I can even appreciate that
many economists might be reluctant to accept a radical policy proposal
like managed inflation, even if it is the natural implication of a thoroughly
conventional model. But what is disappointing is that many economists and
economic commentators do not even seem to perceive the conflict. They know
that price stability is good, inflation bad - and are so anxious to uphold
the canon that their normal analytical sense seems to desert them. Some
fall into naive accounting errors, like imagining that capital can somehow
flee a country without a corresponding current account surplus. Others
invent on the fly all sorts of novel theoretical justifications for the
canon. Japan, you see, is different: expected inflation will actually raise
real interest rates; lower real interest rates will increase savings, yet
have no effect on investment; a weaker yen will do nothing to increase
net exports, but will somehow reduce liquidity; and so on. The people making
these arguments would be justifiably caustic if someone advocating unorthodox
policies asserted that all the relevant supply curves slope down and the
demand curves up; yet it appears that ad hockery in the defense of orthodoxy
is no vice.

I hope for Japan's sake that the outlook is not as gloomy as it now
appears. But if, as I expect, the current recovery strategy fails, there
is another strategy readily at hand - a strategy that is firmly grounded
in the most conventional of macroeconomic models.